Searching for the Rolls Royce of ETFs

I’m writing this this post in between packing my bags for a research trip to the United States. It’s going to be a busy three weeks. One of the highlights will be spending four days at the world’s largest exchange-traded fund ETF conference in Hollywood, Florida.

The conference is a chance to observe first-hand the ecosystem that’s grown up around ETFs. For example, ETFs have helped to make roboadvice possible. They’ve made it easier and cheaper for independent financial advisors to create multi-asset portfolios. And in the US, there are ETF strategists using these instruments to create tactical and dynamic, multi-asset, model portfolios.

It’s only a matter of time before a similar ecosystem grows around ETFs in Australia. In fact, it’s already started.

ETFs are a truly disruptive innovation. The term disruption has become a cliché. Consequently, the term has lost some of its meaning. Clayton Christensen, the Harvard Business School professor who coined the term explains:

In our experience, too many people who speak of “disruption” have not read a serious book or article on the subject. Too frequently, they use the term loosely to invoke the concept of innovation in support of whatever it is they wish to do. Many researchers, writers, and consultants use “disruptive innovation” to describe any situation in which an industry is shaken up and previously successful incumbents stumble. But that’s much too broad a usage.

So, what really is disruption? Why are ETFs deserving of the title? And what should traditional fund managers do in response?

According to Christensen, there are two types of innovations: sustaining innovations and disruptive innovations. Sustaining innovations improve existing products. They allow companies to service the most demanding and sophisticated customers at the top of their market. They result in improved profitability as higher product quality allows companies to charge more for their products and services.

This process continues, sustaining innovation on top of sustaining innovation. Companies keep repeating the process because it worked well (i.e. improved margin and profits) in the past.

Christensen describes the result:

As companies tend to innovate faster than their customers’ needs evolve, most organisations eventually end up producing products or services that are actually too sophisticated, too expensive, and too complicated for many customers in their market.

The company becomes accustomed (maybe even addicted) to a higher profit margin. It develops a cost base that can only be serviced if the company maintains its margin by continuing to produce high-priced products.

This makes it hard for the company to try anything new that might lower its margin. Eventually, the company finds itself in a situation where it’s at risk of becoming a victim of its own success.

Why do we say that? Because focusing on the high price/high margin end of the market creates non-consumption. In other words, there is unmet demand for a product at a lower cost and without all of the bells and whistles. Christensen explains what happens next:

However, by doing so, companies unwittingly open the door to “disruptive innovations” at the bottom of the market. An innovation that is disruptive allows a whole new population of consumers at the bottom of a market access to a product or service that was historically only accessible to consumers with a lot of money or a lot of skill.

What do these disruptive innovations look like? Christensen gives us a checklist:

Characteristics of disruptive businesses, at least in their initial stages, can include: lower gross margins, smaller target markets, and simpler products and services that may not appear as attractive as existing solutions when compared against traditional performance metrics. Because these lower tiers of the market offer lower gross margins, they are unattractive to other firms moving upward in the market, creating space at the bottom of the market for new disruptive competitors to emerge.

ETFs tick most of the boxes on the disruptive innovation checklist. They started out as cheap, low margin/high volume index tracking products. They were unattractive to most fund managers, except index fund managers who were already in the low margin/high volume investment business.

Why would a mutual fund charging a 1 per cent fee want to launch an ETF that only charges 0.10 per cent? They wouldn’t. Besides, why would they want to offer an inferior product? They didn’t. So, they stayed away.

Mutual fund sponsors allowed ETFs to satisfy the unmet demand for cheap, simple, transparent, investment products. They allowed ETFs to gain a foothold unopposed among clients looking for a product that was “good enough”.

Christensen often uses the example of Japanese carmakers entering the US car market in the 1970s. They made compact cars that were good enough and cheap enough for those that couldn’t afford the larger vehicles coming out of Detroit.

There’s no reason why the Big Three couldn’t produce compact cars of their own. But the margins were lower and they weren’t as sexy as a Corvette, a Mustang or a Firebird.

The Japanese were also helped by an important tailwind, a sky-rocketing oil price that made American gas guzzlers suddenly much less attractive.

Once the disruptors gained a foothold, they began to work on sustaining innovations of their own. Before too long, they had moved up the value chain and started producing their own luxury models – Lexus, Infinity and Acura.

A similar thing has happened with ETFs. The industry that started out as a few simple index funds, has morphed into more sophisticated products. At first it was systematic, rules-based strategies and now it includes even fundamental active strategies. We have reached a point were ETFs are probably the better product in many of respects.

Just like our US auto example, ETFs have also been boosted by a few important tailwinds. Investors are demanding greater transparency. The commission structure that supported the selling (yes selling, not advising) of mutual funds has been rolled back in many countries.

More and more advisors are setting up independent businesses; often at the request of clients who no longer trust the mega institutions that let them down. Advisors and asset managers are being held to a higher fiduciary standard. Oh, and active returns have been really, really disappointing.

The US is in the middle of a mad rush by active managers and mutual fund sponsors to launch their own ETFs. Let’s hope that their version of a compact car isn’t a Ford Pinto (which would burst into flames when hit from behind in an accident)!

Seriously, old-school active fund managers should consider offering their clients ETFs. Why’s that? Because they have the opportunity to do it better, provided they can get past their hang-ups of starting a new product that lower their overall margins.

Here’s an example. Many of the systematic, rules-based ETFs select securities and construct portfolios using financial ratios based on accounting data.

Academics have raised concerns around the steady decline in the usefulness of accounting data in predicting future stock performance. For example, see the paper Time to Change Your Investment Model by professors Feng Gu and Baruch Lev.

Active fund managers employ research analysts to create an economic picture of a company. These analysts adjust accounting data on a company-by-company basis.

In other words, they’ve already created the higher quality/higher cost product. They’ve nailed the sustaining innovations that ETFs are trying hard to develop. What they need to do is find a way to deliver a “good enough”, lower-cost version of this at scale.

They need to disrupt themselves first before someone else does.

I hope to share lots of stories from the road when I get back in February. Like the Columbia Student Investment Management Association conference in NYC. The keynote speakers will be value investing legends Seth Klarman and Joel Greenblatt. Until then, enjoy the rest of the summer. Sadly, I won’t get the chance!